) Introduction
In this section, the researcher will utilise books, scholarly articles, journals, websites and other sources to gather information relevant to earnings management. By studying theories and concepts relevant to the subject of study, it gives the researcher in-depth knowledge regarding the subject prior to conducting on field experiments. In addition, Information gathered from the literature review is vital help with testing hypothesises later on in the study.
b) Earning Management: Definition
According to Roychowdhury (2006), earning management is decision-making activities undertaken by managers during financial reporting. This often leads to altering reports or misleading figures/numbers, which sometimes hides the true economic/financial performance of a firm. From this definition, several aspects emerge. Firstly, Managers can use multiple ways to exercise their judgement, in order to influence or alter their final reports. For example, judgement is needed when estimating economic events for the future, which show up in financial reports/statements; like placing salvage values on long-term physical and liquid assets, obligations for retirement benefits, losses from asset impairments or bad debts and deferred taxes. Similarly, managers must also select accounting methods, which are “acceptable and reasonable” when reporting economic transactions. For example, methods such as LIFO, FIFO, straight-line method etc. Moreover, managers must also use their judgement for management related to working capital, such as timing inventory shipments or even keeping a check on inventory levels. These judgements made by manager are vital to the company, since they affect net revenues, and cost allocations. Apart from that, managers also cut expense or reduce resource allocation in advertising, R&D and maintenance as a discretionary measure. Other decisions managers take may also include structuring of corporate transactions. Secondly, the definition states “misleading stakeholders” earnings management as being the purpose of earnings management. This can manifest when managers gain access to or possess information not available to stakeholders outside the firm; as a result, transparency towards such stakeholders is likely to be minimum as argued by Jones (1991).
Beneish (2001) stated that another definition of earnings management states it being the act of making reasonable and legal decisions to ensure financial reports are predictable and stable. It is important to note that this definition does not state the object of “misleading” or “misinterpreting” shareholders or stakeholders. In fact, most scholars believe that this definition truly defines earnings management, which is different from what has been described regarding earnings management. As a result, many literary scholars on the subject of earnings management believe that earnings management believe there are two types of earnings management. Firstly, legal earnings management where managers demonstrate good ethics to make decisions which portray the company earnings or performance in the most accurate manner. Secondly, illegal earnings management where managers manipulate numbers to gain personal benefits or meet specific targets, better known as “cooking the books”. No matter what type of earnings management a manager undertakes or is forced to undertake, it can result in either costs or benefits for the company as mentioned by Cheng and Warfield (2010). Costs in the form of misallocation of funds, overfunding, etc., while benefits like providing accurate information to stakeholders, reducing shareholder expectations etc. can manifest from the act of earnings management. Hence, it is important for the company to understand how to set standards for managers to follow, in order to permit judgement without giving too much liberty where decisions can alter or mislead financial results.
c) Earning Management Incentives
i. Contractual Incentives
Managers are awarded contractual incentives for their performance with regard to managing and forming contracts. External contracts such a dividend covenants, debt contracts, supplier contracts etc. are some of the most common where earnings management comes into play. Since, accounting data is utilized in such contracts, managers are seen to alter or misinterpret data through earnings management in order to meet contract requirements as stated by Bergstresser (2004). For example, the use of data in debt contracts is observed in some banks. Such banks often make companies maintain certain levels of working capital, interest coverage and debt to equity. When companies cannot meet these requirements, the banks can impose severe penalties, which can include higher rate of interests, restrictions on future borrowing and even immediate repayment of loans. Companies that are on the verge or struggling to meet these requirements tend to offer incentives for managers to manipulate numbers. In such a case, the company is more at fault rather than the manager, since the later only does what is best for the company. As a result, managers will use earnings management to misinterpret results to prevent possible penalties imposed by the bank. However, on the other hand, when contractual renegotiations are underway, troubled companies often give out incentives to make their managers reduce profits/earnings estimates as argued by Dye (1988).
ii. Capital Market Incentives
Accounting numbers or financial reports have a direct link with stock market reaction and value of stock shares; as a result, it is common for companies to offer incentives to encourage earnings management for the capital market. Stock market analysts often utilize financial information and reports for interpreting value and making forecasts, which in turn help potential investors select the best possible firm. Hence, companies offer managers incentives to engage in earnings manage to help the company meet or beat analyst predictions. When undertaken currently, managers are able to use earnings management to increase the attractiveness of company shares, and bring in potential investors. Although most firms feel it is important to meet analyst predictions in the capital market, the ideal situation would be when the company surpasses them Xie et al. (2003). Missing earning benchmarks or falling below market expectations can be disastrous for stock returns and could even affect the CEO’s compensation. In most cases, managers utilize earnings management that increases predicted income to meet below par forecasts. On the other hand, when income is higher than predicted, they utilize income-decreasing techniques; however, in such scenarios managers would leave the earnings as it is, in the hope that it would increase stock returns for the company as mentioned by Teoh et al. (1998). This discussion has revealed that companies that naturally do well with a steady increase in earnings are less likely to engage in earnings management and vice versa.
iii. Management’s Personal Incentives
Bergstresser and Philippon (2006) mentioned that often at times, incentives for earning management are provided for non-financial purposes, which usually involves meeting the management’s personal requirements. These requirements are mostly for internal purposes are not linked to external stakeholders like government bodies, unions and shareholders. A common example being a CEO’s actions to manage earnings. CEOs, particularly newly elected ones tend to engage in downward earnings management to demonstrate the company’s need for change during their first year at the helm, only to engage in upward earnings management in the subsequent years to follow. By following this pattern, the newly elected CEO can link improvement or upward trending of company earnings directly to him or her. Similarly, CEO’s leaving a company will also tend to engage in earnings management to leave the company with dignity or help reserve a seat on the board. Such instances of earning management also occurs among other board members or officers lower in the hierarchy like CFOs. It is important to note, that in all the circumstances discussed above, the incentive is non-financial and, usually psychological or mental gratification Xie et al. (2003).
d) Earnings Management Motivation
i. Capital Market Expectations
A company’s financial reports directly related to how well a company is performing with regard to generating revenue and bottom-line income. Companies that do well on the sheets, often advertise themselves as potential gold mines for investment. This is especially important for start-ups companies that have recently released shares in the stock market. Start-ups rely on investment for future expansion; hence, they are motivated to engage in earnings management to portray their firm as smart investment choices. Equity incentives are the choice of reward offered to managers are able to improve the company’s financial outlook in the capital market. Companies utilising such techniques are criticized for being “fake” or “fraudulent” as they then to cheat investors into thinking they are making the best. However, companies back this behaviour claiming that the data they present is not fake, even if it represented in different manner (Beatty et al. 1998).
Ewert and Wagenhofer (2013) commented that insider trading also comes into the equation, when the management wishes to keep more internal investors rather than external ones. In such scenarios, the management tends to downplay company success to detract external investors, which usually helps keep majority of company stock inside the organisation. In addition, personal information related to company’s performance is kept within the organisation to promote insider trading. When such information is disseminated in capital markets, it is often delayed to such an extent, that it proves to be invaluable to investors as mentioned by Noronha et al. (2008).
ii. Regulatory Motivations
Jackson and Pitman (2001) stated that in some industries like insurance, utilities and insurance, companies are regularly monitored to ensure compliance with certain ratios and accounting figures as per industry norms. Insurance firms and banks are especially affected by these regulations (Beatty and Harris, 1999). Regulatory bodies make banks and other financial bodies follow these regulations to ensure that they possess sufficient assets or capital to pay off liabilities. Without these regulations, scandals where banks declaring sudden bankruptcy may emerge. Meeting these requirements are important enough for companies to encourage earnings management. In fact, it common for managers to be given incentives when they help the company meet these requirements through earnings management. Previous research confirms this claim, where reports indicated banks utilising earning management in the following circumstances (Karaoglu, 2005):
• Loan loss provisions/ loan write-offs: Overemphasising loan loss provisions is commonly used to demonstrate losses caused by customer defaults, bad loans, wrong estimates and renegotiated loan terms. By emphasising these losses, the companies on the limit are able to meet the regulation requirements (McNichols, 2001).
• Investment portfolios: Occasionally the company will make abnormal gains via investment portfolios. Recognising these gains serve as an indicator of the company’s compliance with the regulations (Beatty and Harris, 1999).
iii. Political Cost Motivations
When managers are faced with a situation where political wealth transfers are eminent, they undertake earnings management practices that reduce value of such a transfer. They do so by reducing the likelihood of it occurring or the size, and in some cases both as stated by Han and Wang (1998). This hypothesis is often referred to the political cost hypothesis in earnings management and has been documented well in the past. Key (1997) states that managers who tend to undertake earnings management in these circumstances do so in consciousness of private benefits, while other times it may seem that these managers act similar to “agents” while value transfer occurs amongst stakeholders. For example, the government as a stakeholder that makes claims on the company’s profits through corporate taxes. The managers by engaging in earnings management reduces visibility to taxation authorities, essentially preventing unwanted tax audits. On the contrary, earnings management that increases transfer value would result in a “political cost”.
Minimising the value of taxes is an important activity that is undertaken within private firms. Managers often carry out accounting procedures, which not only reduce tax values but also delay payment of corporate taxes to an indefinite period. That being said, firms much not allow such activities to get too aggressive, as it could attract political visibility, resulting in regulatory actions such as audits. When audits occur, it undoes all the accounting benefits brought by earnings management, brining unwanted costs into the equation. Hence, it widely accepted that political costs help moderate economic incentives gained through earnings management as argued by Patten and Trompeter (2003).
Empirical studies have shown that profit making firms often utilise earnings management to reduce corporate taxes as much as possible, without eliminating it completely; since, that my attract probes from tax authorities. Similarly, companies who do not profit as much as others may pay little or no corporate taxes. Such firms are also at risk of tax audits due to low levels of disclosed income; hence, they utilise accounting procedures to demonstrate increased earnings to raise the level of taxes, and eliminate unwanted political attention (Cahan et al. 1997).
Becker et al. (1998) mentioned that there is good reason for companies to avoid tax audits; since, it can increase value of the firm and attract higher corporate taxes in the future. In addition, there are penalties and fines that can be imposed apart from the process being expense to undertake. Hence, this discussion has revealed the nature of earnings management being “sub-optimal” with regard to political costs. It is important to note that in most circumstances, earnings management to reduce tax obligations occurs when a unique setting is present:
No issues with agencies
Absence of information asymmetries
No demands by stakeholders for issuing financial statements
iv. Lending Contracts Motivations
Research on earnings management has developed another hypothesis called “debt covenant”. According to Cornett et al. (2008), the “debt covenant” theory states that creditors generally impose strict restrictions on share buybacks, dividend repayments and issuance of additional debt. This is carried out to ensure that the firm repays its debts or borrowed capital. Now according to the hypothesis, firms deep in debt often place signification importance over earnings management to help meet accounting ratios and figures as expected from the creditor. Since, breaches can lead to penalties and other unwanted circumstances earnings management is motivated to cover or meet these requirements. Furthermore, it is widely accepted that mostly firms on brink of breaching their respective lending covenants are likely to engage in earnings management. In such circumstances, accounting methods like “depreciation accounting” is often utilised. However, some scholars hold the view that such firms are more likely to restructure operations and reduce payments on dividends, rather than engaging in earnings management as argued by Ronen and Yaari (2008).
e) Earnings Management Measurement
i. Total Accruals Model
Thomas and Zhang (2001) mentioned that in accounting, accruals are financial information that is yet to be reported in the books, which includes profits as well as expenses. Analysts often use a ratio called the “total assets to total accruals” to determine the quality of revenue being generated. This is important, as transitory accruals are not fixed sources of income/expense and can vary over a period, resulting in unpredictable affects with regard to revenue quality. Unlike permanent earnings from sales, which are likely to occur repeatedly. In earning management studies, the use of Accruals models has been widely documented in the past couple of decades. The measure of accruals has been used as method to measure earnings management within firms, where two types of accruals determine the level of manipulation. According to Dechow and Skinner (2011), discretionary accruals are directly related to managerial choice/judgement, while non-discretionary accruals are related to the firm’s expected/stated level of accruals. Managers have no control over non-discretionary accruals, with no manipulation possible in this regard; however, discretionary accruals are the primary focus point of measuring earnings management, since managers use their own discretion to make decision that alter financial results.
Since, accruals can significantly influence earnings quality, the higher the percentage of total accruals the lower the quality of revenue or earnings. That being said, it is important to note that accruals could represent either manipulation or normal accounting, and exactly deterring which one is the major driver is quite difficult. According to the Total Accruals Model, determining the total net accruals is simple as deducting cash earnings from accrual earnings.
Figure 1: Total Accruals Model
(Source: Thomas and Zhang, 2001)
Reitenga et al. (2002) stated that in order to calculate “total net accruals” an elaboration of “accrual earnings” and “cash earnings” are required. Actual earnings are calculating the difference between ‘ending’ and ‘beginning’ owner’s equity, while adjusted for dividends, issuances and repurchases of stocks.
Figure 2: Accrual Earnings Model
(Source: Noronha et al. 2008)
In order to understand cash earnings, changes in cash or cash account taken into account. Since, the cash account in firm can be affected through payments to equity holders, adjustments are needed to make an accurate prediction as seen in figure 3 below.
Figure 3: Cash Earnings Model
(Source: Francis and Krishnan, 1999)
ii. Models for Capturing Earnings Management
1. The Healy Model
In 1985, Healy compounded his model for measuring earnings management. Popularly called the Healy model, it uses comparisons between two aspects; firstly, mean total accruals and secondly, partitioning variables in earnings management (Bartov et al. 2008). This model differs from other models of earnings management, in a sense that it predicts the occurrence of systematic earnings management in all periods. The partitioning table that constructed consisted of three separate groups as argued by Kothari et al. (2005). One group for predicting upward earnings management, while the other two for downward earnings management. Pairwise comparison of the first group with the other two of downward accruals helps draw a reasoned conclusion. This helps construct a nondiscretionary accruals prediction model like in figure 4.
Figure 4: Healy’s Nondiscretionary Model
(Source: Bartov et al. 2008)
In the above model, NDA represents estimates for nondiscretionary accruals, while TA stands for the total accruals which is has been scaled up the total number of lagged assets. Moreover, ‘t’ represents the is estimated time period in year subscripts. In addition, the symbol ‘τ’ is used represented a year subscript which demonstrates a single year during the event period as argued by Ecker et al. (2013). Although the model is known to produce accurate results, it is based on unrealistic assumptions where NDACC or Nondiscretionary accruals remains stable across firms over several years. This is the one major disadvantage of the Healy model, which is improved upon by the Jones model, a subject of discussion later on in this literature review as mentioned by Matsumoto (2002).
2. The DeAngelo Model
According to Baber et al. (2011), approximately a year after Healy released his model, DeAngelo released a different method for measuring earnings management in 1986. DeAngelo’s model was improved over the existing Healy model since it incorporated the use of “prior period accrual” or ‘t-k’ for the acting as measure to estimate “normal total accruals” represented as ‘NAt-1’, which was done by using it as a proxy or representative figure for “nondiscretionary accruals” in number of years ‘t’.
Figure 5: DeAngelo Model
(Source: Ecker et al. 2013)
Noronha et al. (2008) stated that when DeAngelo’s Model is compared with Healy’s the following operations are noted; firstly, Healy makes use of ACC or total accruals instead of DACC, while NDACC or nondiscretionary accruals remain identical or constant. While on the other hand, DeAngelo assumes that although NDACC is not the same every years, it is however stable through consequent years. Secondly, DeAngle’s Model utilises prior year’s estimates to calculate nondiscretionary accruals, while Healy makes use of cross-sectional comparisons between DACC and NDACC. Thirdly, the validity and accuracy of results from using both models rely on NDACC and its nature; hence, NDACC with a pattern of “white noise” allows the Healy model to generate error free DACC predictions. On the other hand, if NDACC follows randomised patterns, then DeAngelo’s model for predicting discretionary accruals would generate unbiased results.
The DeAngelo Model along with the Healy Model are subject to producing inaccurate DACC results. This is because, the economic environment within which firms operate, significantly influence their operations. More importantly, in the real world scenario NDACC is variable among firms due to changes in operations that are a direct response of the changing economic environment. Due to this, higher revenues would automatically shoot up NDACC levels even without accounting manipulations as stated by Kothari et al. (2005).
3. The Jones Model
In 1991, Jones introduced her model for measuring earnings management, which estimated accruals while considering it a function originating from firm characteristics. Her model became of the most widely used and appreciated of its kind in earnings management. Islam et al. (2013), argues that that the Jones model is extremely important along with the aspect of accruals decomposition it brings to the equation. Since, the Jones Model was released, research on estimating accruals has widened significantly, with intensive research over the subject, which has resulted in innovations that are derived from the original Jones model. According to DeFond (2010), growth in earnings management literature is largely attributed to the use of “abnormal accruals” as a widely accepted choice for determining earnings quality, which inadvertently is based on Jones’s original literature. DeFond (2010), further goes on to state the evolution of using abnormal accrual proxies is responsible for significant advancements in literature based on earnings quality.
Figure 6: Jones Model
(Source: Dechow, P.M. and Skinner, 2011)
In the Jones Model, accruals are measured by calculating the sum of normal accruals and discretionary accruals, represented as (a) and (b) respectively in equations above. Normal accruals are calculated by measuring changes in ‘i’ or firm’s sales along with PPE or the firm’s equipment, property and plant. In addition, Part (b) of the equation takes into consideration discretionary accruals, where manipulation is assumed. In her Model, Jones assumes that payables, receivables and inventory are current accruals that are generated through sales innovations, while PPE performs deprecation accrual for the firm. Bernard and Skinner (1996), were the first to point out limitations in the model. They pointed out that the model’s description regarding normal accruals determinants were incomplete. In other words, they argued that the model did not include explanatory variables. When explanatory variables are left out of the equation, it can result in poor isolation of discretionary accruals, resulting in some normal accruals becoming a part of discretionary accruals. Hence, observations derived by both time-series and cross-sectionals methods are considered as being homogenous. The problem with this is that even companies operating within the same industry possess different characteristics, something Jones neglected within her model. Moreover, the endogeneity of her model has been an unsettling problem for scholars in the field. That being said, despite the model’s shortcomings, it is a valuable improvement if not a major advancement over previous models. Thanks to these developments in earnings quality studies, several problems of the original model was addressed to create a modified model, which will be discussed in the next section. The popularity of the model helped it overcome its own limitations, something the earlier models failed to accomplish (Jones, 1991).
4. The Modified Jones Model
Islam et al. (2011) mentioned that over the past five years, significant research has gone into finding solutions for problems plaguing the earlier Jones’s Model. Researchers have targeted specific problems related to the model, which have been categories in groups below:
Sample selection, endogeneity and variable biases
Accrual model grouping and estimation
Reversals and time-series properties related to accrual
Designing better economic determinants
Ronen and Yaari (2008) stated that although the above categorisation is randomly selected, they are not mutually exclusive to each other; in fact, some are extremely likely to overlap. However, constructing such a categorisation helps eliminate differences and similarities of each research, while allowing practical solutions to manifest. Of the four categories described above, the fourth one dealing with economic determinants is arguably the least developed and understood. However, research has allowed the earlier Jones model to be modified in way to make it more effective as argued by Klein (2012).
In the Modified Jones Model, several modifications to the original model has been carried out in order to minimise or and even eliminate conjectured tendencies the model previously brought, with regard to the measurement of discretionary accruals. Unlike the previous model, the modified version considers estimations of NDACC during event periods.
Figure 7: Modified Jones Model
(Source: Islam et al. 2011)
ΔRECt in the equation represents net receivables that has been scaled by the firm’s totals assets, while nondiscretionary accruals along with α1, α2 etc. are elements retained from earlier model. However, the most significant difference in the new model is with regard to the adjustment of revenue variations brought by changing receivables. In addition, the modified model makes implicit assumptions that earnings management alone brings out variations in loan or credit sales, as scholars believed it was easier to undertaken earnings management over credit sales rather than revenues generated through direct cash sales. After these modifications to the Jones’s original model, researchers believe that estimates should no longer lean towards “zero”, when samples present earnings management that are undertaken through revenue management (Chung et al. 2012).
5. Performance based Discretionary Accruals
Myers et al. (2007) stated that there is observed relation between accruals and firm performance. Evidence gathered from extant models, economic intuition, cash flows, earnings and empirical studies points out the correlation of accruals with a firm’s existing and past performance. Existing discretionary models like the Modified Jones Model does attempt to assert over current firm performance to reduce its impact on nondiscretionary accruals; however, there is a need to develop strong models that are capable to deliver accurate results despite the influence of firm performance. Some have suggested adjusting the Modified Jones Model by simply deducting corresponding DACCs with the prior year’s return from assets.
Figure 8: Performance based Discretionary Accruals
(Source: Sloan, 1996)
In order to understand the impact of DACC’s on increasing values of earnings, returns and cash flows with regard to compensation, the model in figure 8 was developed. In this model, ΔCOMP represents changes in compensation, which is a combination of salary and bonus over a period spanning year ‘t-1’ until year ‘t’, scaled up via lagged salaries. RET in the equation stands for raw returns, while ΔE represents changes in earnings that has been scaled via “book value” of equity as mentioned during at the year’s starting. In addition, ∆CF is changes in cash flows, which is also scaled by equity with book value. This model utilises two separate indicators to demonstrate DACCs; since, scholars have found pointed out that managers utilise large discretionary accruals to facilitate maximisation of bonuses as argued by Reitenga et al. (2002).
6. Discretionary Revenue Model
Literature on earnings management has documented how managers manipulate revenues in order to meet earnings benchmarks. According to observations made by Dechow and Skinner (2011), firms that are often investigated by powerful agencies like the SEC in the United States, tend to encourage higher levels of revenue manipulation by their managers. McNichols (2001) further adds that such manipulation occurs via deferred and accumulated revenues, through channel stuffing activities carried during the year-end. Channel stuffing activities involve sale figures manipulation by surpassing the channel capacity for selling products.
One of the most notable discretionary revenue model is one described by Stubben (2010), who stated reported revenues is determined by merging of both discretionary and nondiscretionary revenues. In other words, R = RUM + δRM as seen the model equation of figure 9.
Figure 9: Reported Revenue Model by Stubben
(Source: Stubben, 2010)
Using the reported revenue as a base, the model of discretionary revenues in figure 10 was developed. The model is based on the fact that nondiscretionary revenues are invisible, and are part of reported revenues. Due to this, the revenue model always understates reported revenues by a factor of 1-c as stated by Caylor (2010).
Figure 10: Discretionary Revenue Model by Stubben
(Source: Stubben, 2010)
f) Summary
There are several definitions for earnings management, with no leading authority being able to standardise the term. Some consider earnings management as manipulation of financial data through account manipulations, while others reject such acts as being a part of earnings management; instead, they label it as “illegal earnings management”. However, most scholars seem to agree that earnings management all activities whether legal or illegal, alter or change the output of financial reports. Findings reveal that the companies value is significantly influenced by its earnings; hence, gathering relevant and accurate data is vital to the organisation’s attractiveness for future investments. In addition, to increase market value in capital markets, reported earnings serves as an assurance for shareholders, to help communicate the business performance of their investment. The concept of “cooking the books” where managers misinterpret for personal gain has also been highlighted in the concluded literature review, but only briefly.
Literature has pointed out that GAAP serves as the primary guideline for making accounting decisions, which has a strong influence over decision making within the firm. However, GAAP is not legally binding or internationally recognised and hence only serves as widely accepted method or framework for accounting decisions. Earnings management offers different types of incentives; contractual incentives are awarded to managers who demonstrate good performance with regard to forming new as well as managing existing contracts. Capital market incentives are provided to managers who help the company meet their requirements in stock markets, reducing or increasing current and projected earnings. In addition, incentives are also given out to those who help the management with non-monetary or personal favours through accounting decisions.
The strong influence of financial regulatory bodies over firms gives firms sufficient motivation to undertake earnings management. Since, companies often borrow huge sums of capital from financial institutions; they are required to meet specific requirements set by creditors. Falling short of these requirements can result negative outcomes like borrowing and repayment difficulties in the future. In addition, political costs as a motivation for earnings management has also been thoroughly discussed in this review. Companies that report too high or too low earnings seem to be at most risk at facing political costs, which can bring out audits. Since, audits are time consuming, costly and expensive it is something companies try to avoid. Several accrual models have also been discussed, with the Modified Jones Model being one of the most effective models for determining accruals. Finally, for measuring discretionary revenue, Stubben’s model has been thoroughly discussed.
Reference List:
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